After Brexit: How asset classes may fare following the initial surprise
July 6, 2016
The bout of investor uncertainty triggered on June 23 by Britain’s vote to leave the European Union (EU) shocked markets, sending equity markets into a two-day decline and creating volatility in currency markets as well. Now, as investors digest the bigger meaning of Brexit, they must consider what comes next for their investment holdings amid a swirl of ambiguity.
In the quarters and perhaps years ahead, several Brexit-inspired realities could likely shape the global investing climate. The following sections consider how different types of asset classes might fare in the new landscape, incorporating views from our investment teams that might generally help investors as they consider their allocation decisions.
International fixed income
There’s no way around it: Fundamentally, the United Kingdom and Europe are worse off due to the Brexit vote. Going forward, it’s reasonable to expect an economic slowdown within the Union as trade adjustments are renegotiated. This means that volatility could be frequent across fixed income sectors. If there’s an upside, it’s that volatility could bring about opportunities to invest at meaningful discounts. However, any buying activity should be undertaken with a constant focus on risk management, making sure that so-called “buying into the dip” is not done without a fundamental understanding of the security being considered. Put another way: Market dislocations can bring opportunities to acquire assets at discounted prices, but there’s only so much risk one should take in the process. We recommend against chasing an immediate post-Brexit selloff, because we believe the story may develop and change in the near term.
Fixed income allocations could also be influenced by the reigniting of global currency wars, which showed sparks of life immediately after the Brexit results. At this writing, markets are focusing on the U.S. dollar, the British pound, and the Japanese yen, all of which have shown some degree of agitation. What’s more, talk of a devaluation of the Chinese yuan could come back, rekindling the same kind of deflationary spiral as in late 2015.
For investors considering adjusting their fixed income allocations, we believe a bias toward defensiveness could very well make sense. Across the diversified strategies we are responsible for, we are generally taking modest positions in better-value credit markets and running longer-duration positions as a counterbalance. We will continue assessing market reaction to the next policy moves and determine if a shift in portfolio positioning — perhaps skewing even more defensively — might be appropriate. For the moment, we don’t anticipate making material adjustments.
Any type of market shock like Brexit can potentially unearth buying opportunities, particularly because these shocks can cause prices to drop for nonfundamental reasons. (That is, prices might soften for reasons that are unrelated to factors such as company financials, competitive position, and strength of management.) Bargain hunting can be productive at the margins of a portfolio, although it makes sense to avoid disrupting the core holdings.
Europe’s push-and-pull has remarkably less influence in Asia than it does in other parts of the world, however. Commercial trade exposures to Europe are low, accounting for less than 4% of gross domestic product. With that in mind, we think a prudent approach here is to focus on companies that derive most of their earnings close to their home markets, emphasizing companies that are leveraged to domestic demand and local consumption (and less exposed to global markets). All along, we believe in pursuing companies that show solid fundamentals, sustainable earnings, and responsible corporate governance.
Real estate securities and income-oriented equities
Amid a global "flight to safety," we tend to see positive support for lower-risk, longer-duration assets, particularly those domiciled in the United States. Real estate investment trusts (REITs) tend to fit this description. We think it makes sense to remain overweight in the U.S., underweight in Europe, and underweight in emerging markets. To inject a bit of opportunism, we turn to the British pound, whose depreciation could extend for some time. Depending on how far it goes, there may be some buying opportunities in the U.K. residential sector. Already, there are signs of price declines in that space.
An additional note on European REITs: On the whole, they appear to display decently strong fundamentals. They are benefiting from factors that include a general rebound in real estate prices, steady rents, and falling construction costs. Nonetheless, in light of the uncertainty about what lies in store for the EU, we think it makes sense to scale back exposure.
Small- and mid-cap growth
Investors who seek a deeper understanding of company-level performance — across the capitalization spectrum, not just the lower end — should probably take into account the increased role that currencies are likely to play in the weeks and months ahead. Concerns about currencies go back even before Brexit, but they are obviously amplified now.
We think it makes sense to stay a bit underweight in most cyclical sectors, such as energy, materials, manufacturing, and financials. For the most part, there is a positive case to be made for companies that conduct a majority of their business in the U.S.
Small- and mid-cap value
Investors should keep in mind that this slice of the market is inherently exposed to sectors that are sensitive to interest rates, particularly because most of the relevant market indices presently have large weights in financials and REITs. Because of this rate sensitivity, financial services companies could face some pressure. They could see their valuations decline, which may provide opportunities at reasonable entry points, though, as always, investors should make sure such opportunities are only undertaken with care.
For small and midsize companies that operate mainly in the U.S., the economic picture isn’t entirely compromised by the Brexit vote. The U.S. recovery looks as though it will continue on a modest track, and a procyclical positioning could be appropriate.
International value equities
Investors who hold allocations to international equities may notice a heightened interplay between stock performance and currency markets. Consider that shortly after the voting results were announced, Japanese equities and U.K. equities moved in a counterintuitive way, with U.K. stocks leading European markets while Japanese shares were among the weakest within developed markets. This unusual performance was partly based on currency effects, as a stronger yen put pressure on Japanese shares and a weaker pound was positive for U.K. stocks.
Further manifestation of currency effects could probably be expected at the sector level. Consider what happened within two traditionally defensive areas in the days after the vote: The telecommunications and utilities sectors experienced some variability among sector constituents, primarily owing to their underlying currencies.
Global growth equities
For the U.K., the possible effects of Britain’s departure are complicated and broadly considered negative, though they don’t necessarily apply to all companies and sectors. It is probably reasonable to say that Brexit implies higher European sovereign risk and a structurally weaker pound for some indefinite period. Additionally, given an environment of heightened uncertainty, we think there is an increasing likelihood of headwinds for financial institutions, travel-related industries, and companies that are exposed to the consumer. We are also wary of increased pressure on non-U.K. companies that have substantial operations in the U.K. or derive significant revenues from the U.K.
While we may eventually advocate some portfolio construction decisions driven by the Brexit news, it is unlikely we will recommend any major change in approach or positioning within the portfolios we manage. We have been in the “new normal / lower for longer” camp based on market anomalies that have been in place for years now, and the Brexit event only reinforces that general outlook.
Staying focused amid the noise and disruption
In the near term, Brexit headlines will likely rail about choppy and volatile markets that are coping with a heavy dose of uncertainty. Anxiety about the unknown is understandable, but investors would be well served to stay grounded, take the long-term view, and focus on time-tested habits of sound investing. These include:
- PATIENCE. Britain’s exit will have complex implications with primary, secondary, and tertiary effects on particular countries, regions, companies, and markets. The patient investor will therefore avoid hasty decisions, choosing instead to parse out the fundamental questions that will truly matter in what could be years ahead. The patient investor will also continue honoring his or her financial objectives, remaining committed to the long run.
- A DELICATE APPROACH TO OPPORTUNISM. Market declines often present genuine buying opportunities, but just as often, they expose weaker holdings that might not have the stamina to recover. We believe downside protection should be top of mind when thinking about new positions in the wake of a market shock.
The fallout from the U.K.’s vote to leave the European Union has been quick to emerge. Investors have many questions, and the answers won’t become clear quickly. Watch this space for additional insight as markets move beyond this initial uncertainty and begin forming stronger assumptions about post-Brexit conditions.
The views expressed represent the Manager's assessment of the market environment as of July 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views. The investments referenced herein may not be suitable for all investors.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Diversification may not protect against market risk.
Narrowly focused investments may exhibit higher volatility than investments in multiple industry sectors.
REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations.
Investments in small and/or medium-sized companies typically exhibit greater risk and higher volatility than larger, more established companies.
International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt. Fixed income securities may also be subject to the risk that principal is repaid prior to maturity.